Introduction

Definitions
A. Option Contract- Obtain rights in exchange for
monetary transfer
a. Call- right to purchase underlying security at a
specific price
b. Put- right to sell
c. American vs. European Option
d. Writer- seller of option contracts.
B. Futures Contract
a. Delivery of a specified good by the seller for
payment of an agreed amount at some fixed future
date.
b. Both sides of an obligation
c. Cash does not change hands between buyer and
seller until delivery.
C. Option on futures Contract- Option to buy or sell a
futures contract. Allows for standardization of underlying
asset.
D. Swaps- Exchange of cash flows between two parties.
Generally fixed for flexible.
E. Arbitrage-Simultaneously purchase and sell the same
good at different prices. Forces prices to converge.
Why these markets are valuable
a. Modification of risk-return opportunity set.
a. Hedging- reduces risk of holding the underlying
asset
b. Speculation- highly levered portfolio that is
easily obtainable.

b. Provides information concerning the underlying asset

displayed in an organized market.
c. Provides for more efficient markets by creation of
arbitrage opportunities.

Options market Overview

Variables that describe an options contract.
1. Type (put, Call)
2. Underlying asset (IBM, GE etc)
3. Exercise or strike price
4. Expiration date
5. Example IBM March 85 call

Types of Underlying assets

1.
2.
3.
4.

Stock Options (65%)

Stock Index Options (15%)
Commodity Options (5%)
Futures Options (5%)

Typical Specifications on American Stock Options

1. Options traded in 3-month cycles with up to 2 adjacent
months.
2. Generally 3 to 5 dates traded at one time
Need choices for spreads and various risk trade-offs.
Also want liquidity.
3. Strike prices in $2.50 increments till $25/share then $5.00
increments
4. New strikes prices open up as prices change.
5. 100shares/option

Open Interest

1. Number of contracts outstanding

2. Up if both buyer and writer are establishing new
position.
3. No change if either side is liquidating position
4. Down if both sides are liquidating position
5. example

Market Mechanics
1. Exchange Floor participants
a. Floor brokers- Commission traders who cannot
trade for own acct.
b. Market makers- Trades only for own account
c. Order Book Official- Keeps track of all limit orders
2. Clearing house
a. Matches buyers and sellers each day.
b. Assigns writer in delivery process.
c. Serves regulatory function (sets position limits,
guarantees writer performance etc.)
3. Exercise procedure
a. Buyer has right to exercise.
b. Writer is assigned obligation from clearing house
c. Options expire on 3rd Friday of delivery month.
All outstanding options with value are exercised
at that time.
d. Opening rotation - starts earliest month low
strike to high. May take as long as 10 minutes to
establish prices.

Introduction to Valuation
Terminology
1. Intrinsic value
a. Call = Security Price minus Exercise Price
if positive otherwise 0.
b. Put = Exercise Price Security Price if
positive otherwise zero.
2. Time value = Observed option price minus its
intrinsic value.
3. In-the-money = option with positive intrinsic
value
a. Stock price > exercise price for calls
b. Stock price < exercise price for puts.
4. Out-of the money = intrinsic value is zero.
5. At expiration an Option is always worth its
intrinsic value.
Graphical depiction.
1. Maximum value for put but not for call
2. Minimum value zero for both given limited
liability of option.
3. See graph
Notation to be used
1. S = Stock price
2. E = Exercise or Strike Price
3. T = Time till Expiration
4. i = Risk Free interest rate.
5. C = Call Price

6. P = Put Price
7. PV( ) = Present Value of whats in Parenthesis

Boundary Limit Propositions

Assumptions
1. Call options will be considered first
2. More is preferred to less
3. No taxes or transactions costs
4. American Option unless otherwise specified.
5. No Dividends
Proposition 1.
C > 0 this is the minimum call price
Proof:
Since there is limited liability for the option
it can never be worth less than zero at
expiration. Therefore it cant be worth less
than zero today.
Proposition 2.
C > Max (S-E ,0) Call must be worth its intrinsic
value.
Proof:
If not buy option and exercise.
Example
S = 25 E = 20 C = 4
Buy Option -4 Must pay for the option
Exercise
-20 Must pay for the stock
Sell Stock +25 market price
Profit
+1
Graph of new boundary

Proposition 3.
C(E1) > C(E2) given E1 < E2. Lower exercise
price worth at least as much as higher exercise
price all else equal.
Proof:
Consider a portfolio of buying E1 option and
selling E2 option.
Look at all possible portfolio values at
expiration.
1
S* < E1 < E2 E1
C(E1) = 0
= S* - E1
C(E2) = 0
= S* - E2
Port = 0

2
3
< S* < E2 E1 < E2 < S*
C(E1) = S*- E1
C(E1)
C(E2) = 0
Port = S*- E1

C(E2)
Port =

E2 E1
Therefore since portfolio will never have
negative value at expiration it cant have
negative value today which it would if C(E1) <
C(E2). If it did you could buy the portfolio today
collect the cash flow and never have to pay it
back.
Also since the maximum value of the port at
expiration is E2-E1, the maximum difference is
price has to be the present value of E2 E1. If

not sell C(E1) buy C(E2) and put proceeds in

bank. Bank value at expiration will be greater
than E2 E1, which is the most you will have to
pay at expiration.
Show on Graph.

Proposition 4.
C(T2) > C(T1) given T2 >T1. Options with a
longer time to expiration cannot have less value.
Proof:
At expiration time T1, C(T1) = max S*- E or 0
and from Prop 2. C(T2) must be worth at least
the same so it has to be worth at least the same
today.
Proposition 5.
C<S
Proof:
Stock can be considered an option with infinite
time to expiration and zero expiration price.
From Prop 3 and 4 its must be worth at least as
much as any option.
Proposition 6.

C > Max(0, S-PV(E)) A Call option must be worth

its discounted intrinsic value.
Proof:
Consider two portfolios:
Port A: Own a Call
Port B: Own stock
Borrow PV(E)
Compare all possible values of each portfolio at
expiration
S<E
S >E
Port A
C =0
C= S*- E
Port B
S= S*
S=S*
Must pay back E
Must pay
back E
S*- E <0
S*- E
Port A more valuable
Portfolios have
equal value
Therefore, since at expiration Portfolio A will
always be worth at least as much as Portfolio B,
it must be worth at least as much today.
Example of an arbitrage situation:
C = 3, S =55, E = 50, PV(E) = 49
Call is below discounted intrinsic value which is
$5.
Buy Call 3 (Buy Port A) today
Sell Stock +55 and Lend $49 = -49 (Sell Port B)
today
Positive cash flow of 55-49-3 = $3 today.
Since we know the call will be worth at least the
other two at expiration we keep the $3 and
maybe more if S*<50.

Show graph with new boundary condition.

Implications
1. longer time to maturity implies higher
lower boundary since PV(E) is smaller i.e
S- PV(E) larger.
2. higher interest rate implies higher lower
boundary.
Same reasoning.
4. both shift lower boundary to the left in graph.

Variables used to determine the Call Price

Variables determining Intrinsic Value
1. Exercise Price
Negatively related to call price
2. Stock Price
Positively related to call Price
Time Value
3. Interest rate
Positively related to Call price
Think of owning a call as not having to purchase stock
till some future date. Therefore higher interest rate
implies larger savings.
4. Volatility
Positively related to Call Price
Profit on gain but limited liability on loss.
5. Time to maturity Positively related to Call price
Better chance to profit on gain and more savings by not
having to buy till later.
Show relationship movements on Graph.

Proposition 7:
Given on Dividends, never exercise an American Call early.
Proof:
If exercised buyer receives intrinsic value i.e. Max(0, S-E)
However before expiration from Prop 6
C > Max (0, S PV(E)) which is greater than intrinsic
value. Therefore never exercise early.
Hence American Call price = European Call Price

Intuitively, this is because as seen above calls always have

positive time value before expiration and exercising foregoes
that value.
Proposition 7:
If Stock pays dividend an American Call may be exercised
early.
Proof :
Stock price falls on ex-dividend by the amount of the
dividend. However, since option holder is not stockholder, he
does not receive Dividend. Therefore, if dividend is greater
then time value left in the option, he is better off exercising
right before ex- dividend since lost time value will be less
than lost intrinsic vale from stock price decline.
Example:
S = 52 E =50 Company will pay $1 dividend tomorrow.
There is $.50 of time premium left in option.
If not exercised option will be worth $1.50 tomorrow.
Therefore, better off getting $2.00 today.
If Time premium was $1.25 no need to exercise since option
is worth $2.25.

Put Propositions
Proposition 1:
P>0
Proof: Do to limited liability cannot be worth less than zero
at expiration.
Proposition 2:
P > Max (E-S, 0) Put must be worth its intrinsic value.
Proof:
If worth less buy option and exercise.
Example
S = 22 E = 25 P =2
Buy Put
-2
Buy Stock
-22
Exercise
+25 buy delivering stock
Profit
+1
Graph boundary

Proposition 3:
P(E1) < P(E2) given E1 < E2
Same as call example by forming portfolio of buying P(E2)
and Selling P(E1).
Look at all possible portfolio values at
expiration.

1
2
3
S* < E1 < E2 E1 < S* < E2
E1 < E2
< S*
P(E1) = -(E1- S*) P(E1) = 0
P(E1) =
0
P(E2) = E2 - S*
P(E2) = E2- S*
P(E2)
=0
Port = E2 - E1
Port = E2- S*
Port =
Therefore since portfolio will never have
negative value at expiration it cant have
negative value today which it would if P(E1) >
P(E2). If it did you could buy the portfolio today
collect the cash flow and never have to pay it
back.
Also since the maximum value of the port at
expiration is E2-E1, the maximum difference is
price has to be the present value of E2 E1. If
not sell P(E2) buy P(E1) and put proceeds in
bank. Bank value at expiration will be greater
than E2 E1, which is the most you will have to
pay at expiration.

Show on Graph.
Proposition 4:
P(T2) > P(T1) given T2 >T1. Options with a
longer time to expiration cannot have less value.
(American options only.)

Proof:
At expiration time T1, P(T1) = max E - S* or 0 and from
Prop 2. P(T2) must be worth at least the same so it has to be
worth at least the same today.
Proposition 5:
P < (E) Put cannot be worth more than its exercise price.
Proof:
Since stock minimum is zero maximum put intrinsic value is
E. Therefore it cannot be worth than E at expiration or worth
more than the Present value of E today. (American Option).
Graph.
Proposition 6:
P > Max ((PV(E) S) , 0)
Proof:
Consider Two portfolios
Portfolio A : Own a put

Portfolio B : Sell stock

Lend PV(E) amount of cash
Compare all possible values of both portfolios at expiration
S<E
S >E
Port A
P = E S*
P= 0
Port B
Stock = -S*
same as before
Gets E back
E S* for both
Port A more
valuable
Since 0 > E-S*
Show graph
This boundary is less restrictive then intrinsic
value boundary. Proposition shows a negative
component to the time value of a put.
Implications
1. longer time to maturity implies lower
boundary since PV(E) S* is smaller than
E-S*.
2. higher interest rate implies lower
boundary.
Same reasoning.
both shift lower boundary to the left in
graph.
Variables used to determine the Put Price
Variables determining Intrinsic Value
1. Exercise Price
Positively related to Put price
2. Stock Price
Negatively related to Put Price

Time Value
3. Interest rate
Negatively related to Put price
Think of owning a call as not having the proceeds from
selling the stock until some future date. Therefore
higher interest rate implies larger foregone income.
4. Volatility
Positively related to Put Price
Profit on gain but limited liability on loss.

5. Time to maturity

Could be positively or negatively

related to Put price
Better chance to profit on gain but more foregone
income buy not selling stock till later.

Show relationship movements on Graph.

Proposition 7:
An American Put may be exercised early.
Proof:
If (E S)(FV) > E-S* then you are better off
exercising today because value at expiration is
greater than max value on Put.
Doesnt hold for call since max value does not
exist.

Intuitively early exercise will also occur if

negative component of time value dominates to
positive component. This happens if there is
certainty that E S* will occur at expiration. In
this case owning a put will always give you the
same payout as selling stock and lending so its
better to get the funds today.
Show on graph

Put- Call Parity

For European options
P = C S +PV(E)
Proof:
Consider the following Portfolios
Portfolio A: Own a Put
Portfolio B: Own a Call
Sell Stock
Lend PV(E)
Consider all possible portfolio values at
expiration

S* < E
Port A:
Port B

P = E S*
C= 0
S = -S*
Get E back
Port B value E - S*
Both Ports same value
same value

S*>E
P=0
C = S* -E
S = -S*
Get back E
Port B = 0
Both Ports have

Therefore if both worth the same at expiration

then they must be worth the same today. If not
buy port with less value and sell one with higher
value.
Implications
1. If S=E Call will be worth more than Put.
Both options only have time value and
Call value is higher.
2. May not hold for American options. Why?

Index Options
Underlying Asset
1. Consists of a portfolio of securities
2. Gives purchaser to right to purchase an
amount of dollars equal to the index value
multiplied by some multiplier.
3. Example
a. S &P 500
b. Nasdaq 100

c. S &P 100 (OEX)

4. Exercise procedure consists of cash settlement
as determined by multiplying the intrinsic
value at the close of trading by a given
multiplier.
a. Example
b. OEX 450 Call with S* = 456.50. Cash
settlement would be $6.50 * 100 = $650.
c. Can be difficult to create cash position in
an arbitrage.
Extra Risks with cash settlement
1. Timing risk Writer doesnt know of exercise
till the following day.
i. Cash settlement in effects liquidates
position in the market.
ii. Buyer can announce intent to deliver for
about a half hour after the market closes.
iii. Therefore, if news comes out after the
close buyer has option to liquidate
position before the opening the next day.
iv. Not true with stock options since stock is
received upon exercise
v. Example
1. Index value = 246 a 240 C = 7 at
the close of trading.
2. Bad news comes out on the market
and the Index value is expected to
go down 2 points on the open.
3. Can liquidate now and get $6 will
only be worth about $5 or so
tomorrow ($4 of I.V. $1 T.V.)

4. With stock options you get the stock

so you still take the loss.
2. Early exercise risk during trading hours.
i. Option may trade below its intrinsic value
during trading hours without pure
arbitrage available.
ii. Because intrinsic value is not determined
till the end of trading that day.
iii. Example

Use of Binomial Model to obtain Specific Option

Price
Beginning assumptions
1. Perfect capital markets (no taxes, transactions
costs, etc)
2. No dividends
3. Risk free interest rate known and constant
4. Distribution of stock price movements known
5. European option
6. Two possible outcomes for every period in
time
Steps in determining no arbitrage option price
1. From portfolio theory since options and stock
are perfectly correlated a risk free portfolio
can be created.
2. Buy stock and sell calls or buy stock and buy
puts.
3. Assume there is one-period till expiration
a.
Observe possible stock and option
combos at expiration that yields the same
value for both states of nature. (Sell calls
and buy puts)
b.
Let S + - C+ = value if Stock price rises
c.
Let S - - C- = value if Stock price falls
d.
Find share of stock purchased per call sold
to equate both states. (Delta)S + - C+ =
(Delta)S - - Ce.
Delta = (C+ - C-)/(S+ - S-) Will always be
between zero and one.

f.

g.

This is a risk free portfolio, therefore value

can be discounted at risk free rate to find
portfolio value today.
Given stock price is known today can
solve for option price today.

4. Example
a.
S0 = $50, E = $50 Prices will rise or fall
50% next period. Risk free rate = 25%.
b.
Delta = (25 0)/ (75- 25) =
c.
Own one stock and sell 2 calls.
d.
Portfolio values at expiration are
i. 75 2(25) =25 or
ii. 25 2(0) = 25
iii. worth $25 no matter what state occur
e.
Value today is $25/(1 + .25) = $20
f.
$20 = S 2C =$50 2C or C =$15
g.
show one period tree
5. A pure arbitrage exists today if call does not
equal $15
a.
Say C=$10 then buy two calls sell stock
and lend $20.
b.
To
T1- T1+
i. Buy 2 calls -20
0
+50
ii. Sell stock +50 -25 -75
iii. Lend $20 -20 +25
+25
iv. Value
+10 0
0
v. Keep $10 for all states
c.
Do Opposite if C > $15

6. Observations
a.
Two assets can be combined to make a
third, therefore arbitrage forces
deterministic price.
b.
No investor risk preferences needed.
c.
Stock price is the only random variable
market risk does not matter.
d.
Probability of up and down movement not
used.
e.
Hedge ratio always between 0 and 1.
f.
Show graph from example.
7. Call price depends on the following variables
a.
Size of stock price movement (Vol ) S+
=80 and S- = 20 implies C = 17
b.
E = 60 implies C = 7
c.
Int rate = 20% implies C = 14.58
d.
Longer time to expiration (must look at
two period model)
8. Two- Period Model.
a.
Must start at expiration and work
backwards for each state of nature
b.
Show two period tree and example.
c.
Hedge ratio must be adjusted each period
9. One Period Put
a.
Combo is for purchase of stock and put
b.
From example S+ + P+ = (Delta) S- + Pc.
Delta = (P+ - P-)/ (S+ - S-)
d.
Delta = -25/50 = -1/2. Buy 1 stock and 2
puts
e.
Value at expiration is $75 in both states
f.
$75/(1.25) = $60 = S + (2)P = 50 =2(P)

g.

P = $5

10. Two period put is worth less why?

11. General formula for n period binomial
a.
C = S x F(a,n,p) E x f(a,n.p)/(1 + r)n
b.
Where
i. F = binomial distribution function
ii. n = number of periods till expiration
iii. a = lowest # of up moves for call to
be in the money at expiration
iv. p = size of the up or down move
v. f(a,n,p) = hedge ration to be
readjusted each period.
Black- Scholes Formulation
Added assumption to binomial
1. Market operates continuously
2. Stock price movements are also continuous
3. Stock Price follows a log normal distribution
due to limited liability on the downside.
4. show graph
Value of a call is the Present value of expected cash
flows from holding option.
1. Find the expected area under the curve from
log normal distribution.
2. If cash flows can be evaluated at some end
point with specific boundary conditions then
the differential equation can be solved.
3. Relate to graph

The Black- Scholes equation is C = S . N (d1) E

e-rt .N ( d2)
1.
2.

3.
4.
5.
6.

7.

N( ) = cumulative normal distribution function

d1 = (log(S/E) + (r + .5 . var) (T))/ (Stand Dev. .
T1/2)
d2 = d1 ((s.d.) . T1/2)
T = Time to maturity in a fraction of a year
r = risk free rate
N (1.00) implies .8413 is Prob of a
standardized variable (z- stat) is under 1.00.
Show in graph

Interpretation of Equation
1. As variance goes to zero, N(d1), and N(d2)
approach one since Z score up.
C = S E e-rt
No volatility premium only time value of
money
Show on graph
2. N(d1) = hedge ratio or delta of position =
C/S
This is the slope of the line on graph.
Changes in S, T, or will change delta
i. S up implies delta up since N (.) up.

ii. T up implies delta could go up or

down depending on in or out of the
money
iii. up implies same could be up or
down
iv. r up implies delta up.
c. Rule of thumb is that delta is approximately .5
around PV(E).
3. Gamma = Delta / Stock price
Measure of portfolio stability
Positive gamma implies that delta up
when stock price up
Largest when stock price is around
exercise price.
Also becomes larger when Time to
expiration is shorter and stock price
around exercise price.
Becomes smaller when time to expiration
is shorter and stock price is not around
exercise price.
See graph.
4. Theta = C/T Also known as time decay
Multiply change in time by theta to get
price change
Considered negative for calls since calls
lose value over time.
Also not linear. Theta increases as
expiration approaches.
Most negative at the money.
5. Kappa = C/

 Positive for calls. As volatility goes up call

price goes up
Also greatest at the money.
Put Valuation
1. Black-Scholes Model
a. P = C S + PV(E)
b. P = E . e-rt . (1- N ( d2)) - S . (1 -N (d1))
2. Put Delta = N(d1) 1
a. Same as call delta 1
b. Always negative
c. Call delta + absolute value of put delta
always equals one.
3. Put Gamma
a. Same as call gamma.
b. Always positive and largest at-the-money
4. Put Theta
a. Could be positive or negative.
b. Depends on the various time value
components
5. Put Kappa same as for calls
Other Uses of B/S Valuation model
1. Can get implied volatility of stock given option
price

2. All options should be priced with same

volatility
3. Delta or Hedge ratio important to arbitrage
mispriced options.
Show real world examples of option characteristics
Problems with B/S in practice
1. Can only be used if life of option known
a. Problems with puts and calls with
dividends
b. Multi-period Binomial may be a more
accurate model
2. Must take dividends into account
a. Substitute S PV(div) for S into B/S
equation
b. Dividend must be known
c. Option must not be exercised early
3. Must continuously adjust hedge ratio to stay
risk free if arbitrage appears available.
4. What is true measure of Volatility?

Strategies
Background
1. Types of positions
a. Naked Purchase or sale of a single type
of option
b. Hedged- Portfolio of both underlying asset
and option
c. Spread- Purchase of one option and sale
of another
d. Combination- Portfolio containing both put
and call options
2. Profit graphs
a. Look at profits at expiration for various
potential stock prices
b. Profit on vertical axis Stock price on
horizontal.
c. Example Stock ownership
3. Analyze components before expiration (delta,
gamma, theta, kappa)
Naked Positions
1. Call Buying
a. Show expiration graph
b. Example S =49, E = 50 C = 3 Delta =.45
Gamma = .04
i. Max loss = 3
ii. Breakeven at expiration is S* = 53
c. Positive Delta, gamma, Kappa

d. Negative Theta i.e. the position loses

money over time
e. Show todays graph
f. Which option to pick (exercise price and
time to exp.)
i. Lower exercise price implies less
leverage, more stable delta.
ii. Longer time implies greater premium
iii. Graph of different exercise prices
2. Call Writing
a. limited profit, relatively unlimited
downside
b. Show graph and previous example for
writer
c. Negative Delta, Gamma and Kappa.
d. Positive Theta i.e. the position makes
money over time.
e. I-t-m vs. o-t-m
3. Put Buying
a. Maximum loss, limited profit
b. Example E= 50 S = 49 P = 2 Delta = -.55
Gamma =.04
c. Show expiration day graph
d. Negative delta, Positive Gamma, Neg
Theta (Generally), Positive kappa.
e. Show todays graph
f. Time premium lower with puts.
g. In-the-money vs. out-of-the-money.
4. Put Writing
a. limited profit, relatively unlimited
downside

b. Show graph and previous example for

writer
c. Positive Delta, Negative Gamma and
Kappa.
d. Positive Theta i.e. the position makes
money over time.
5. Buying Stock
a. Show graph
b. Delta is always positive one, gamma is
zero theta is zero.
Synthetic Positions
1. Synthetic Long Stock
a. Buy call + sell put
b. Combine individual graphs
c. Example E = 50 S = 49 C = 2 P =2
i. Deltas must add to one
ii. Graph example
d. Smaller investment for synthetic
i. Implies must have smaller profit at
expiration
ii. Position will lose money over time.
Losses should equal the interest lost
on buying stock relative to buying
synthetic stock.
iii. Call premium is greater than put
premium.
2. Synthetic Short Stock
a. Sell Call + buy Put
b. Delta always equals 1.

c. Profits are greater for synthetic then

shorting stock.
d. Graph
3. Synthetic Puts and Calls
a. They follow from Put-Call parity.
b. Buy Put = Buy Call and Sell Stock
i. Max loss is the premium on Call plus
(E-S)
ii. Example E= 50 S = 48 C=1
1. max loss is three at expiration
2. breakeven is at S = 47
iii. Difference between synthetic put and
actual is the interest earned on
selling the stock to create put.
iv. Show graph
c. Buy Call = Buy put + Buy stock
i. From above example maximum price
must the put be?
ii. Synthetic Call will be more expensive
since you have to borrow to buy
stock.
iii. Show graph
Hedged Positions
1. Covered Call Write (Write Call against Stock
Ownership)
a. Gives downside protection but limits
upside gain
b. Show expiration day graph
c. Example E=50 S=51 C=4 Delta = .55

i.

Max profit is $3 for S* =50 or more.

Breakeven is S =47
ii.
Go through example in detail.
d. Delta of position = Stock Delta (+1) Call
Delta
i. Delta goes from 1 to zero as stock
price rises
ii. What will of position do over time?
e. Gamma of position is negative since delta
down as stock price rises.
i. Position gets more bearish as prices
rise and more bullish as prices fall.
ii. Dont want a lot of movement
f. Theta is positive
i. Position makes money over time
ii. This is because we sold time
premium on the call.
g. Different exercise prices
i. O-t-m
1. higher max profit (allows stock to
appreciate)
2. higher breakeven ( Collect
smaller premium)
3. Example E= 55 S =51 C =1
4. Max profit = 5 B.E. is 50
h. Check volatilities to find best option
2. Protective Put (Put Buying with Stock
Ownership)
a. Limited liability with no Maximum profit
b. Show expiration graph
c. Example E = 50 S = 51 P = 1 Delta =
-.45

i. Maximum loss is 2
ii. Breakeven is S = 52
d. Delta of Position = stock Delta + put
Delta
i. Always positive between zero and
one
ii. .55 from example
e. Gamma is Positive (As stock price rises
put delta falls therefore position delta
rises).
f. Graph with todays position
g. Theta is negative
i. Position loses money over time
ii. Bought option so lose value over
time.
h. I-t-m vs. o-t-m same as for calls
3. Comparing Covered Calls and Protective
puts
a. Graphical comparison
b. From example can determine under what
various stock price each strategy
dominates
i. Calls max profit is 3 and Put max loss
is 2
ii. Therefore Calls will dominate
between S =44 and and S = 55
Puts otherwise
iii. Calls better for small movements
Puts better for large movement
iv. What happens as volatility of Stock
rises? Does it change your opinion?
Complex Hedges

a.
b.

1. Ratio Call Write

a. Sell more than one Call against
stock ownership
b. Advantages and disadvantages over
simple covered call
i. Adds more premium income therefore
increase downside protection
ii. Creates exposure on upside because of
uncovered short call position
c. Construct expiration day graph for 2/1 ratio
i. Max Profit occurs where E = S
ii. Breakeven points for both upside and
downside
d. Example S = 49 C = 3 E = 50 Delta of Call
= .45
i. Max profit = 7 Downside breakeven
=43 upside Breakeven = 57
ii. Profits eared over a range
e. Delta of 2/1 position
i. Delta goes from +1 to negative one.
Near +1 if options are way out of
money. 1 if way I-t-m.
ii. From example the delta of position is
zero i.e. delta flat.
iii. Position becomes bearish as stock
prices rise and bullish as stock prices
fall.
f. Gamma
i. Negative since as stock prices rise delta
falls.
ii. Dont want movement in stock.

iii.

Gamma is greater than for simple

covered call since there are more
options
g. Theta is positive position makes money
over time
h. What happens with higher ratios?
2. Variable Ratio Write
a. Sell Calls with two different exercise prices
b. Maximum profit occurs over a range
between the exercise prices.
c. More stable than ratio write since gamma
is smaller especially around exercise
prices. Lower max profit since one option is
in-the-money and one is out.
d. Example and graph.
4. Ratio Put write
a. Sell stock and sell more puts
b. Same graph as ratio call write
c. Therefore same characteristics
d. Graph and example
5. Reverse Ratios have exactly opposite
characteristics

Spread Positions: Purchase of one option and

sale of another
1.

Bull Call Spread

a. Buy low E sell high E
b. Always a debit transaction
c. Bull spread because it makes profit if
prices rise
d. Max profit and max loss
e. Example Buy C45 = 3 and Sell C50 = 1 S
=45
i.
Max gain = 3 and Max loss = 2
ii.
show graph
f.
Delta is Positive to neutral since lower E
has higher delta. ( Put deltas on
example position)
g. Gamma is neutral goes from slightly
positive to slightly negative
h. Theta also can be positive or negative.
Depends on whether low E or high E
option dominates
i.
O-t-m spreads more aggressive max
profit higher but need more movement
for profits. Delta is more positive.

2.

Bull Put Spread

A.
Buy low E and sell
high E
B.
Credit transaction
C.
Same
characteristics as bull call spread
D.
Show graph

3.

Bear Spreads
a. Sell low strikes and buy high strikes
b. Profits if stock price fall
c. Cash inflow for calls outflow for puts
d. Graph
e. Delta negative, all others similar as bull
spreads.

4.

Butterfly Spreads
a. Uses three exercise prices
b. Combines a bull and bear spread
around the middle price
c. Buy low strike, sell 2 middle strikes and
buy high strike
d. Show basic graph
e. Example of call butterfly S =49 , C45 = 6
C50 = 3 C55 = 1
i.
Max loss at S = 45 is 6
6 + 1 =1
ii.
Max profit at S= 50 is 1
+ 6 1 =4
iii.
Graph example
f.
Delta is relatively flat. Goes from
slightly positive to slightly negative.
g. Gamma is also relatively flat
h. Theta depends on location
i.
Risk is low with limited profits. May
have high commission
j.
Reverse ratio buy middle E sell outsides

6. Ratio Call Spread

a. Buy Low E Calls and sell more high E Calls

b. May be either a credit or debit

transaction.
c. Graph
i. Below Low E keep proceeds
ii. Between low and high E keep
premium from high E and get return
on low E.
iii. Above High E, lose on uncovered call.
d. Example
e. Buy C50 = 5 and Sell two C55 = 2 where S =
54
i. Max loss at E =50 is 5 + 4 = 1
ii. Max gain at E = 55 is 0 + 4 = 4
iii. Draw graph
f. Delta of position goes from Positive to
negative
i. From example what is Delta/
ii. What is smallest delta from example
g. Gamma is negative for most of the
position
i. As long as neg delta from sales are
greater than delta from purchase
ii. When is gamma positive?
g. Theta is positive over most of the position
h. What happens as ratio increases?
i. Ratio spread vs. ratio write
i. No downside risk with spread
ii. No premium with stock so higher max
profits with ratio write
iii. No dividend with Spread.
7. Ratio Put Spread
a. Buy high E sell more low E

b. Graph position
c. Similar characteristics to Ratio Call spread
8. Reverse Ratio spreads (Backspreads)
a. Sell low E buy more high E
b. Maximum loss is at high E
c. Can flip example above
d. Graph
e. Characteristics are opposite to ratio
spreads.
f. Watch out for early exercise on in the
money options that are sold especially
with puts.
9. Time Spread
a. Sell Nearby option and buy Option with
longer time to maturity.
b. Cash outflow since longer term has higher
price.
c. Example E = 50 S=48 C(t1) = 2 C(t2) = 5
i. Max loss at T1 is equal to initial
investment since worst case is all
options have zero value
ii. Max Profit is uncertain because price
of C(T2) is not certain at T1.
d. Graph at expiration of nearby option
i. Max profit takes place at S* = E.
1. Since at prices below E keep
premium on nearby while
deferred increases in value as S
increases.
2. While at prices above E the
position loses dollar for dollar on

nearby option but only makes

delta on deferred.
ii. Max losses at the tails
e. Delta could be positive or negative
f. Gamma is generally negative except in
the tails
g. Theta is generally positive except again in
the tails.
Combination Positions
a.
b.

1. Straddle
a. Buy a Put and a Call with the same
characteristics.
b. One will be in-the-money and one will be o-tm.
c. Max loss is S* = E since neither option will
have any value.
d. Example E = 45 S = 44 P =2 C = 2
i. Max loss is 4 at 45
ii. Show graph
e. Delta could be positive or negative. From
example?
f. Gamma Positive, Theta Negative, Kappa
Positive
2. Strangle
a. Different Exercise Prices of Put and Call
b. Less initial investment if both o-t-m but
max loss is greater.
c. Example of o-t-m strangle S= 37 C40 = 2,
P35 = 2

P40 = 4

ii. Max loss is $4 between S*= 35 and

40 since both options are worthless.
iii. Breakeven is at 31 and 44.
iv. Show graph
d. Example of I-t-m strangle S= 37 C35 = 4,
i. max loss between S* = 35 to 40 is $8
(initial Investment) - $5(value of put
plus call) = $3.
ii. Breakevens are 32 and 43.
iii. Show graph
iv. Compare the two.

3. Sell either just the opposite.

Arbitrage Positions
1.Conversion (Buy stock and buy put, sell
call)
a. Position is simultaneously buying and
selling stock.
b. Profit if cost of position is less than the
present value of the exercise price.
c. Example S = 53 C50 = 5 P50 = 1
i. Cost of position is 53 5 +1 = 49
ii. At expiration position is always
worth 50
1. S* > 50 implies S* - (S*- 50) + 0
= 50
2. S* < 50 implies S* - 0 +(50- S)
= 50

iii. Since its always worth E or 50 at

expiration it must be worth the
present value of E today.
iv. Otherwise but position finance and
collect 50 at expiration for arbitrage
profit.
2.Reversal (Sell stock, sell put and buy
call)
a. Profit if credit from position is greater
than the present value of E.
b. Position will cost E at expiration for all
states of nature. Therefore if the credit
today plus interest on the credit held till
expiration is greater than E an arbitrage
profit exists.
c. Example
3.Debit Box Spread (Buy Bull call spread
and Bear Put Spread)
a. Buy low E and sell High E Call, and Sell
low E and Buy high E put.
b. Position must be worth the difference in
exercise prices at expiration. Therefore it
must be worth the present value of the
difference today. If less, then buy borrow
and collect value at expiration for a
profit.
c. Proof. Buy C50 ,Sell C60 , Sell P50 , Buy P60
i. If S*>60 call spread worth 10 Put
spread worth 0 at expiration
ii. If S* < 50 Call spread worth 0, Put
spread worth 10 at expiration.

iii. If 50 < S* < 60 then the sum of the

two spreads worth 10 at expiration.
iv. Therefore position must be worth
the present value of 10 today. If less
than buy spread and borrow. Will
pay back less than 10 at expiration
and collect 10 for position.
4.Credit Box Spread (Buy Bear call Spread
and Bull Put spread)
a. Sell low E and buy High E Call, and buy
low E and Sell high E put.
b. Position must cost the difference in
exercise prices at expiration. Therefore it
must be worth the present value of the
difference today. If more , then buy lend
credit and collect value at expiration for
a profit.
c. Proof. Sell C50 ,Buy C60 , Buy P50 , Sell P60
i. If S*>60 call spread cost 10 Put
spread worth 0 at expiration
ii. If S* < 50 Call spread worth 0, Put
spread costs 10 at expiration.
iii. If 50 < S* < 60 then the sum of the
two spreads costs 10 at expiration.
iv. Therefore position must be worth
the present value of 10 today. If
more than buy spread and lend
credit. Will be worth more than 10 at
expiration and repay 10 for position.

Value of the Firm in an Options Framework

I. Assumptions
A. Pure discount Bonds issued
B. No Dividends
C. Capital Structure Unimportant
D. Other B/S Assumptions apply
E. Let Vo = So + Bo
1.
Where Vo is the value of the
firm today
2.
So is the value of equity
today
3.
Bo is the value of debt
today
A.
B.
C.
D.

II. Value of Equity

A. Consider equity an option with Exercise being
the face value of the debt and the time to
expiration the maturity date of the debt.
B. Intrinsic Value of So > ( V* - Bd , 0) Where Bd is
face value of debt.
C. Graph
D. Price today can be obtained from Black/Scholes
model.
1. So = Vo * N(d1) - Bd e-rt * N(d2)
2. Same characteristics as call option
3. Delta positive, Gamma Positive, Theta
Negative, Kappa Positive.
III. Value of Debt

A.
Intrinsic value of B = Min (Bd , V*) Either the
bond gets paid off or the debt holders get the
firm.
B.
Graph at expiration
C.Bond purchase could be considered as buying
the firm and writing a covered call to sell it back
at the face value of the debt.
D.
Can find Bo from total value and B/S
equation.
Bo = Vo - So
a.
= Vo - (Vo * N(d1) - Bd e-rt
b.
* N(d2))
= Vo * N(-d1) + Bd e-rt *
c.
N(d2)
E.Delta is Positive, Gamma negative Theta
Positive, Kappa Negative.
F. Show todays graph
IV. Implications
A. V* up implies B up and S up.
B. Vol up implies B down and S up.
i.
Especially around the exercise price
ii. Limited liability for stockholder, Max Profit
for bond holder.
iii. Shifts value from bondholder to stockholder
C. T down implies B up and S down
D.i up implies B down and S up.
V. Convertible Bonds

Futures Markets Introduction

I.

Definitions
A.

Futures Contract- Delivery of a specific good

by the seller for payment of an agreed
amount at some fixed future date.
1)
Both sides have an
obligation
2)
Everything but price fixed by
exchange
3)
Cash does not change hands
till delivery

B.

Forward vs. Futures Contracts

1)
Individual Agreement vs.
Organized Exchange
2)
Implies only futures markets
are standardized contracts.
3) Clearinghouse settles al futures contracts
4) Security Deposit vs. Marked-to-market
a. Must pay initial margin (1% to 10%)
b. Profits and losses marked-to-market
every day
C. Marked-to-market example and price paid at
delivery
1) Buy a futures contact promising to pay
$98,000 for $100,000 face value worth of
T-bonds.
2) Tomorrow value of contract becomes
worth $99,000

3) Buyer gets $1,000 credit into margin

account. Seller has $1,000 debited.
4) If prices dont move again buyer pays
$99,000 at delivery. But costs $98,000
due to intermittent cash flow.
5) This procedure allows every contract to
be interchangeable. You dont have to buy
from original seller.
D. Margins
1) Initial is 1 to 10 percent
2) Maintenance margin is 60 to 80% of
original
3) Margins set by exchange and can change
E. Terminology
1. Long vs. short
2. Nearby vs. deferred contract
3. Basis (futures price minus the spot price)
F. Characteristics for a successful contract
1. Non- Perishable underlying asset
2. Standardizable quality
3. Large and widely held deliverable supply
4. Competitive cash market
5. Large number of potential hedgers
G. Types of contracts
1. Agricultural Goods (Only contracts till
1973)
2. Industrial and Precious metals
3. Financial
a. Foreign exchange
b. Government securities

c. Eurodollars
d. Stock Indexes
4. Raw materials (Heating Oil)
II. Mechanics
A. Participants
1. Hedgers Have or will have a spot
market position and wish to reduce the
uncertainty about futures prices.
2. Speculators No spot position
a. Scalpers (in and out of positions in a
few minutes)
b. Day traders (hold position
throughout the day)
c. Position traders
B. CFTC (Regulatory Body)
1. Evaluates new and existing contracts
2. Protect against market manipulation
Buy futures contract
a.
b. Own the deliverable supply
C. Clearinghouse
1. Matches buyers and sellers each night
2. Marks positions to market each night
3. Guarantees no defaults
4. Inspects and certifies the deliverable
supply
D. Primary markets
1. CME
2. CBT

3. New York Mercentile

4. COMEX
5. London International Futures Exchange
III. Economic Justification
A. Provides Information: Futures price conveys
info about expected Supply/demand
Conditions
B. Risk shifting through hedging
1. Separates price risk from operating risk
2. Shifts risk from hedger to speculator
a. Holder of spot is sell futures contracts
b. Want to hold later will buy futures
contracts
C. Increases market efficiency
1. No price risk implies firms can lower profit
margin
2. Reduces search costs for information
Valuation of Futures Contracts
I.

Valuation of Forward vs. Futures Contracts

A. Price vs. Value

1. The value of futures and forward contracts
are initially
zero.
2. Price is some observable number used as a
benchmark to determine future value.
B. Value of a forward contract
1. At expiration time T, the forward price is
equal to the spot price.

2. The value at expiration is Vt = St F, where

F = the price of forward contract when
purchased.
3. Prior to Expiration: Vt = PV( Ft F) which is
the present value of the change in price
discounted by time to expiration.
C. Value of Futures Contract
1. At Expiration
a. Price is equal to spot price f t = St
b. Value = 0 as soon as daily mark-tomarket occurs.
2. Before expiration value reset to 0 after
daily m-t-m.
D. Forward vs. Futures Differences
1. No difference 1 day prior to expiration.
2. Otherwise difference is function of
movements in futures prices relative to
interest rate movements.
a. If interest rate is constant Forwards =
Futures
b. Otherwise relative prices depend on
correlation between movement in interest
rates and futures prices.
c. If Int rates and futures price are positively
correlated then futures are worth more
d. If opposite then futures are worth less.
e. Example
II. Pure Cost of Carry Model

A. Four Costs of carrying a Commodity till

Expiration
1. Storage Costs
2. Financing Costs (Interest charges on
Purchasing and holding asset till expiration)
3. Possible Transportation costs
4. Insurance costs
B. Cash to futures pricing relationship
1. f0,t < S0 ( 1 + Ct )T where
a. f0,t is the futures price today with
expiration time t
S0 is the spot price today
Ct are all carrying costs/period with T
periods till expiration.
b. Otherwise arbitrage from buying spot,
financing and selling futures contract
c. Example S0 = $400 (say gold)
C = 10%/ year
Six months till expiration
Futures contract = $440
Cost is $400 + 20 = $420 get $440
make $20
2. Similarly f0,t > S0 ( 1 + Ct )T must hold
a. Opposite presents arbitrage (buy f, sell
spot, lend)
b. Example if futures contract is $410
Assumes no restrictions on short sale
and can invest funds.
3. Therefore
f0,t = S0 ( 1 + Ct )T must hold
4. Similar relationship for relative futures
contracts

C. Effect of Market Imperfections

1. Bid-ask Spread and other direct transaction
costs
a. Pay the ask for buying spot, get bid for
selling spot
b. Forms a wider no-arbitrage boundary
condition.
S0 (1-Tr) ( 1 + Ct )t < f0,t < S0 (1+Tr) ( 1
+ Ct ) t
Where Tr = Transactions costs
c. Discuss inequality
2. Unequal Borrowing and Lending rates
a. Let CL = lending rate and CB = borrowing
rate
b. then S0 (1-Tr) ( 1 + CL )t < f0,t < S0 (1+Tr)
( 1 + CB)t
3. Short Selling Restrictions
a. May preclude arbitrage of f0,t < S0 (1+Tr)
t
( 1 + CB)
b. due to use of funds, no short selling or
availability of spot asset.
c. Widens no-arb lower bound for futures
price
4. Limitations to Storage
a. Pure carry model assumes storability
b. Effects upper bound
c. S0 (1-Tr) (1 + CL )t < f0,t may not hold
since cant buy spot and deliver in future.
5. Example
a. Spot gold = $400, CB= 10%/ year, CL=
8%/year

Tr = 1% on bid-ask spread, 1%
commission and storage costs
b. No-arb becomes
400(1.04)(.98) < f0,t < 400(1.05)(1.02)
407.68 < f0,t < 428.40
c. Different costs for different traders
III. Breakdowns in Carry Model
A. Convenience Yield: Futures trade at less than
full carry.
1. Buy futures and sell spot is not done
2. Return for holding physical product.
3. Physical Asset in Short Supply
a. Not enough traders willing to sell spot
and buy back later
b. Need commodity (seasonal
supply/demand conditions) with limited
storage) or short selling restriction
B. Backwardation: Cash price exceeds futures
price or nearby exceeds deferred futures
prices
IV. Futures Prices and Risk Premia
A. With no premium futures price = E[S]
B. Risk premium may exist if all speculators are
on one side of market.
C. Keynes Theory of Normal backwardation
1. Assumes speculators are net long and
hedgers net short

2. Speculators need an expected return to

take on risk therefore, f< E[S] to give
speculators expected return
D. Opposite of hedgers are net long. A
Contango market may exist.

T-Bill Contract
1. Spot Commodity Characteristics
A. Pure Discount instrument
B. Issued in $10,000 Face Value
Demoninations
C. Maturities of 91 and 182 days issued every
Tuesday
D. Price quotes
i. P = ( 1 dt(n/360))(Face Value)
ii. n = days to Maturity
iii. Example dt = 5% N= 90 days FV =
$10,000
1. P = (1- .05(.25))(10,000) = 9,875
2. Futures Contract Specs
A. $1 Mil Face Value for 90,91 or 92 day T-Bills
B. March, June, Sept December delivery
months
C. Expiration date is the third Wed of the
delivery month.
i. Deliverable only exists for three months
prior to expiration
ii. Is created by the six month T-bill auction
3 months before expiration

D. Price Quote = 100 annualized yield

1. Example yield of 5.20% P = 94.80
2. Easy to know what yield is being traded
3. Actual delivery price is (1- .05(.n/360))
(1,000,000)
4. Minimum move is (.0001)(90/360)(1 mil)
= $25
E. Margin is approx $1500 initial, $1000
maintainance
F. Uses of short term futures contracts
1. Speculate on short term movements in
interest rates
2. Sell futures to hedge against rising
interest rates
a. Companies who may issue S. T. debt in
the future
b. Underwriter protection against short
term security
sale.
3. Buy futures to protect against fall in short
term rates
a. Investor wants to purchase short term
securities
b. Offset lower proceeds from variable
rate loans
Eurodollar Contract
I. Definition - U.S. Deposits held in a
commercial bank Outside the U.S.

A. Libor used as market rate (London

Interbank offer rate)
B. Contract $1mil in U.S. Deposits held in
foreign banks
with 90 days to
Maturity.
C. Quotes are the same as with T-bill contract
D. Differences with T-Bill contract
1. Cash Settlement
2. Libor is determined by mean of a sample
found over two points within the last 90
minutes of trading from a random
selection of 12 reference banks.
3. Yield is add-on vs. discount yield for
Bills
Add-on = (discount amount/ price)
(365/N)
N = days to maturity
Example T-bill = 6% discount
amount is $15,000
Add-on =
(15,000/985,000)(4) = 6/09%
E. Largest volume of any short term
instrument
T-Bond Contract
I.

102-05

Spot Market
A. Auctions with maturities in Feb, May, Aug.
and Sept.
B. Pays principle at maturity, interest Semiannually
C. Quoted in 32nds of a % of par example

interest.

D. Invoice price = price plus accrued

A.I. = N (coupon amt/365)
N = days since last payment

Dec.

II. Futures Contract

A. $100,000 face value of 6% coupon bond
with at least 15 years to maturity
B. Price quote in 32nds with 100 face value
C. Delivery dates March, June, Sept and

month

D. Can delivery anytime during delivery

E. Can delivery other than 6% coupon bond
but must be the same issue on entire
amount
F. Conversion Factor adjusts for delivery off
other than 6% coupons
1. price of the bond if it had a 6% y-t-m/

price
10% y-t-m.
formula

2. example
a. 20 years to maturity 10% and
b. Price if 6% yield = 146. 23 Show

c. C.F. = 146.23/100 = 1.462

G. Finding the cheapest to Deliver
1. Multiply conversion factor times
futures price.
2. The invoice price is this amount plus
A.I.
3. Compare cash market price to (C.F.)
( F.P)

4. Choose bond that gives deliverer

greatest relative amt.
5. see example
$31.25

H. minimum tick = (.03125)(1000) =

Stock Index Futures

I. Spot Market
A. Price weighted - (DJIA)
B. Value Weighted (S&P 500, Nasdaq etc)
C. Equal Weighted (Russell 2000, Value
line)
II. Futures Contracts - There are many recently.
A. Most have both regular and mini contracts
B. The minis are traded electronically, regulars on
open outcry C. All contracts are cash settled
D. S&P 500 Specs
1. Regular contract size = 250 * Index Value
2. Minis are 50* Index value
3. March, June Sept and Dec delivery months
with expiration being Thursday before the
third Friday.
4. Settlement base on closing pot price on last
day.
5. Contract movement min is .10 *250 = $25
on Reg.
6. Margin approx 10% initial and 70% of initial
for maintenance

E. Uses
1. Adjust portfolio exposure for little cost
2. Short term substitute for an equity
position
3. Highly leveraged way the speculate on
market.

Hedging
I. Definitions
A. Short Hedge Holder of position worried about
falling prices.
B. Long hedge- Holder of position worried about
rising prices.
C. Direct Hedge Hedger offsetting deliverable
asset
D. Cross Hedge- Hedger not offsetting
deliverable asset
1. Many more cash assets than futures
contracts
2. Limited number of expiration dates on
futures contract
3. Limited size of each contract.

E. Risks in hedging and ways to reduce it

1. Basis Risk Especially for cross hedges
a. Random shocks do not always have an
equal effect on both cash and futures
prices.
b. Trend movement since carry gets
smaller over time
c. More predictable basis implies more
effective hedge
d. Find the best contract for a given asset
1. horizon- futures contract should expire
near end of hedging period but must also
be liquid.
2. May need to rollover nearby contract
3. Must find the best hedge ratio.
2. Margin risk
a. Provision of funds for Marking-to-themarket
b. Do not want to have to close futures
position early
c. Adequate reserve depends on Volatility
and contract
type
3. Quantity risk
II. Basic Nave Hedge hedging example Hedge dollar
for dollar
A. In one month you will have $1mil to invest
B. Interested in a 6.5% y-t-m t-bond maturing in
20 years
C. Current price = 104-08
D. What is the concern?

1. Worried about interest rates falling

2. Need to buy futures contracts
E. Buy 10 June T-bond futures contracts at P =
98-10
F. Suppose interest rates fall
1. Cash price becomes 107-30
2. Futures price becomes 101-00
3. Made 2-22 on futures but lost 3-22 on cash
4. Hedge did not eliminate risk because the
basis narrowed.
III. Determining the best hedge ratio to eliminate
price risk.
A. Portfolio Theory Hedge ratio. (Minimum
Variance Hedge)
1. Consider a two asset portfolio (futures and
spot holdings)
2. sf2(f) + 2Cov(sf)*f
Where f= number a futures contracts per 1 spot
holding This follows from Portfolio theory
3. Want to find the minimum variance portfolio
a. Take the derivative with respect to change
in the number of futures contracts held and
set to zero
b. 2*(f(f)) + 2*cov(sf) = 0
or f = - Cov/(f) is the risk minimizing hedge
ratio
c. This is also Beta from the regression:
1. s = a + B(f)
2, show plot
4. A measurement of hedging effectiveness
a. 1- (var(h)/var(u) =effectiveness
b if var (h) =0 perfectly effective 1-0 =1

1=0

if var(h) = var(u) hedge ineffective 1-

5. Example: Beta = 1.25 implies sell 1.25

futures per spot held.
6. Problem is one of stability
a. what if optimal Beta changes over
time?

b. Then optimal hedge ratio from data

may not be
optimal

applicable in future
7. If Beta =1 is optimal nave hedge is

IV. Price sensitivity hedge (Duration Model)

A. Duration: Weighted Ave. time to maturity of the
PV of all
Cash flows
1. D = ( (T)*((Coup)/(1 +i)t )/ (Price of bond)
2. D approximates ( i)/ i)
Which is the price sensitivity of a change in
interest rates
3. Example
4. (= -Dur * (i / (1 + i))
5. -Dur * (i / (1 + i)) * B
6. From example
$
7. Higher duration implies more price sensitivity
to int rate
change

B. Using Duration to hedge

1. f-Durf * (if / (1 + if)) * f
2. Therefore Nf = f = (Durb / Durf) (B/f) ((1
+ if)/ (1 + i)
3. Example

C. Problems
1. Assumes yield curve constant over hedging
period.
Otherwise durations change.
2. Must estimate relative changes in yields if
there are any

Hedging Examples
I. Corporate borrower- Borrows a variable rate loan
A. Borrows $2 million at prime rate + 1%
Payable quarterly for next three quarters
B. Borrower is worried about rates rising
C. Sells futures contracts over life of loan
D. If rates rise losses offset by futures gains
E. Want to hedge using Eurodollar contract Sell
2 contracts
F. Currents conditions
1. Prime rate = 7%
2. Spot Eurodollar = 5%
3. June Eurodollar futures contract = 95.00 or
5%
Sept Eurodollar futures contract = 94.5 or
5.5%
Dec. Eurodollar futures contract = 94 or
6%
4. If prime rate is stable at Eurodollar = 2%
expected

$42,500

Payments are:
June = 8% or (2mil)(8%)(1/4) = $40,000
Sept = 8.5% (2mil)(8.5%)(1/4) =
Dec = 9%
(2mil)(9%)(1/4) = $45,000
Total expected interest expense =

$127,500
G. Assume in June Prime rate goes up to 8% but
basis
remains the same.
1. Spot Euro = 6% loan payment is 9%
2. June payment = (2mil)(9%)(1/4) =
$45,000
June Futures Contract = 94 since euros at
6%
Profits are (100)($25)(2) = $5,000
3. The hedge was successful since the basis
didnt move.
H. Have to go through it two more times to
complete hedge.

II. Investor has $1 mil to invest in one month

A. Interested in a 4% coupon 7- year note
selling at par
B. Concerned rates will fall
C. Buys 10 10-year note futures contracts.
Currently yielding 4%
Price = 116-11 (116,351) Show on board
D. In one month rates rise to 4.5%
1. Cash bond only costs $97,026

2. Futures price is $111,973 (6% coupon,

10 year note)
3. Made 100,000 97,026 or
$2,974/$100,000 on spot
4. Lost 116,351 111,351 or $
4,378/contract on futures
5. Net loss is $1,404 * 10 or $14,040 on
investment
E. Needed to buy less futures contracts since
duration of
futures was greater than cash.
(Use price sensitivity hedge ratio)
(Durb / Durf) (B/f) = Nf

Strategies

I. T-bill Futures price determination

A. Let P(t1) and P(t2) be the price of discount
bonds paying
$1 at times t1 and t2 respectively
B. Let t1 be the expiration date of a t-bill futures
contract and
Let t2 be the maturity date of Bill delivered at
t1.
C. Compare the following portfolios
1. Buy time t1 security
HPR = (1- P(t1))/P(t1)
2. Buy time t2 security and sell Futures
contract
HPR = (fp P(t2)/ P(t2)
3. Since both portfolios held for same time
HPRs must
be the same
4. Setting them equal and solving for fp
fp = P(t2)/P(t1)
D. Also one can substitute
1. 1/(1 + it1 ) = P(t1) therefore
fp = P(t2)( 1 + it1 )
2. This is the pure carry model carrying the
deliverable
to expiration.
E. if fp > P(t2)( 1 + it1 ) In this case the yield
from holding
2 period bill is higher than return on one
period bill and
Futures contract therefore,
1. sell futures contract
2. Buy P(t2) bill

3. Finance by selling P(t1) bill

F. if fp < P(t2)( 1 + it1 )
1. Buy futures
2. Sell P(t2) bill
3. Buy P(t1) bill
II. T-Bond Futures Contract Price Determination
A. f*(CF) = B( 1 + it1 - ib)
1. if f*(CF) > B( 1 + it1 - ib)
Sell futures contract
Buy cash bond and finance at rate it1
2. if f*(CF) < B( 1 + it1 - ib)
a. Buy futures contract
Sell bond and lend proceeds
b. This arbitrage presents some unique
problems since
Short initiates delivery proceed
1. What is the holding period? Delivery
can take
Place anytime throughout the month
2. What bond will be delivered?
B. Special options for short in T-bond contract
1. Quality option short delivers cheapest
bond
2. Timing option delivers anytime
throughout the month
3. Wild card option Gets till 9:00 p.m to
deliver
4. End of month option Can deliver after
contract expires

C. Empirical results similar to T-bill.

1. f*(CF) > B( 1 + it1 - ib) appears to be
the norm
2. Again t-bill holder is better off buying
bond
and selling futures contract.
2. There is some reinvestment rate risk to be
considered
III. Stock Index Futures
A. f = S(1+ i d)
Where d = dividends paid over holding
period
B. Index arbitrage and program trading
1. Computer directed index arbitrage
2. Since inception could trade index via DOT
a. Designated Order Turnaround
b. Can be used to by S&P index with one
trade
c. $5 mil minimum
d. Reduced the potentially large
transaction costs
3. Could have caused crash in 1987
a. Futures < spot plus carry
b. Used DOT to buy futures and sell cash
c. Helped to push cash down further
d. Eventually spiraled out of control
e. As a result DOT turned off after large
move
C. Problems with arbitrage
1. Transactions costs have been reduced
dramatically

options

with advent of ETFs (QQQ, SPDRS etc).

2. Short sales on spot
3. Cash settlement must leg out position like

D. Can use futures to arbitrage stock index putcall Parity

1. P = C + (E f)/ (1 + 1)t
2 . Consider two portfolios
Port A: Own a put
Port B: Own a call
Sell futures contract at f
Lend (E f)/ (1 + 1)t
0
At E
if S* < E
Port A
E- S*
If S* > E
Port A

Port B
0 (S* -f) + (E-f) = E S*
Port B
1
(S* -E) +(E-S*) = 0

Spreading Strategies
I. Types of spreads
A. Intermarket- Same Commodity, Different
Exchange
Pure arbitrage doesnt happen very often
B. Intercommodity

1. Different but economically related assets

2. Usually same maturity but could be different
markets
3. Example expect the yield curve to steepen
a. interest rates on t-bills will fall relative to
t- notes
b. Buy t-bill futures and sell t-note futures
4. Other common spreads S & p vs. small cap
index
Gold vs. Silver etc.
C. Intramarket
1. Same commodity different maturities
2. Better if non-perishable
3. example gold contracts should equal cost of
carry
If you think rates will narrow buy nearby
sell differed

rate.

D. Intra and Intercommodity Spread

1. T-Bond Spread gives an implied forward

2. Should be equal to the T-bill futures

contract
3. If not buy one and sell the other

Options on Futures Contracts

I. Definition Option to buy or Sell a Futures Contract
A. Last day of trading in month prior to expiration
of futures
contract.
B. For T-Bonds- 5 days prior to first notice day of
futures cont.
C. Exercised Commodity is a futures contract at E.
1. Clearinghouse creates long position for
buyer, short for
Seller.
2. Credits and debits must be made upon
exercise
3. Example T-Bond
a. Strikes are offered at 1% of par i.e 101,
102 ect.
b. Options traded in 64ths of 1%
c. Say futures contract is at 101
d. The June 100 call may be selling today
for 2-32
thats $2.50/100 or $2,500/ $100,000
e. if at expiration f = 101 option buyer gets
$1,000 credit
and option writer owes $1,000
II. Economic Rationale
A. Expands to set of hedging opportunities
1. Suppose you are a money manager who
may or may
not purchase T-bonds in 3 months
2. With futures only how do you hedge

it.

3. With options let it expire if you dont need

B. Allows to have options on a standardized

commodity
C. Lets futures market speculators reduce some
risk of holding
position
III. Valuation

IV. Early Exercise of Call and Put options on Futures

contracts.
A. Both puts and call may be exercised early
B. Consider deep-in the money call.
a. if f* > E is assured then delta of option is 1.
Then
both assets move dollar for dollar
b. No money tied up in futures contract
however there is a
premium paid on call option
c. if exercised investor has the same profit
opportunities with
no cost
d. not the same with stock options, must
commit funds upon
exercise.
C. Example
1. T-Bond futures option E = 101 with f = 107
2. Will get a $6,000 credit if exercised

3. If profit opportunity till expiration are

identical why not.
V. Binomial formulation
1. Riskless hedge consists of a position in the
futures option and an opposite position in the
underlying futures contract.
2. Similar to equities except that the value of
the futures contract is zero at time zero
3. No initial investment required in futures
contract.
4. No foregone income from holding put or
savings from holding call.
5. Therefore, interest rate term not needed in
finding hedge ratio.
6. Example
7. General B/S equation
a. C = F . N (d1) E . e-rt .N ( d2)
b. However no interest rate term in N (d1)
or N ( d2) terms
Exotic Options
I.

Forward Start Options Options life begins in the

future but paid for now. Generally at-the
money when the life begins. Often used for
executive compensation.
A.3 dates to consider
1. Valuation date t(o)(todays date)

2. Grant date t(g) date when the options life

begins
3. Expiration date (T = time to expiration)
B. When life begins, Option has T- t(g) time
left. T(o) t(g) life gone
C. Value from B/S
1. Time to expiration in model is T-t(g)
2. C = F . N (d1) E . e-r(T-t(g)) .N ( d2)
3. Value today is C . e-r(t(g)-t(o))
D. Example
II. Compound Options The underlying asset is also
an option.
A. Buy the right to pay X for an option with
Strike Price E.
B. Let E and t(2) be the exercise price and
expiration date of the underlying option.
C. Let t(1) be the expiration date of the
compound option.
D. Pricing is from the date of expiration of the
compound option
1. From t(1) to t(2) option pricing is as
before.
2. Must decide at t(1) whether or not to
exercise.
3. at t(1) C = max (Cu X, 0 )
4. Will exercise if S at time t(1) implies Cu >
X
5. Need a bivariate cumulative normal
distribution since two events must occur.
6. Show example

7. Four types ( call and put options on call

and put underlyings)